Rev. Rul. 73-39

Advice has been requested whether gain from hedging operations under the circumstances described below qualify as gross income from sources within less developed countries within the meaning of section 4916(c)(1)(C) of the Internal Revenue Code of 1954.

X, a foreign corporation incorporated in a country that is not a less developed country, owns all of the stock of Y, a less developed country corporation incorporated in Country S where Y operates a copper mine. For the current accounting period, Y sold the entire output of its mine to a smelter in Country T. The agreement of sale provided that the price of each shipment of copper was to be determined by reference to the price of copper on the London Metal Exchange at the time it arrived in Country T, a period of from one to two months from departure in Country S to arrival in Country T. During this period, any decline in the London Metal Exchange price of copper would reduce the price Y would receive for the copper. On the other hand, any increase in the price of copper during transit would increase the price Y would receive.

To eliminate any risk of loss by Y resulting from a decline in the price of copper between shipment and arrival dates, X engaged in hedging transactions on the London Metal Exchange. Each hedging transaction consisted of entering into a "short" sale contract at the time of the shipment of actual copper from Country S for the future delivery of a quantity of copper corresponding to the actual copper shipped. A "long" copper contract identical in amount to the short sale was purchased at the time of the arrival of the actual copper in Country T in order to close out the hedge.

For the current accounting period, X reported on its income statement a gain from the hedging transactions, an amount which comprised over 20 percent of its entire gross income for such period. Y, on the other hand sustained losses for the same accounting period. For financial purposes, X and Y reported earnings for such accounting period on a consolidated basis wherein the gains from the hedging transactions were netted against the proceeds from copper sales as a method of determining the amount Y realized from copper sales.

Section 4916(c)(1)(C) of the Code provides, in part, that a less developed country corporation means a foreign corporation which for its accounting period derives 80 percent or more of its gross income from sources within less developed countries.

The specific issue in the instant case is whether the gain from the hedging operations engaged in by X on the London Metal Exchange should be included in X's income or considered business insurance against Y's losses and applied against Y's losses. If such hedging profits are considered X's income for its accounting period, then X would not qualify as a less developed country corporation for such period since such income is sourced within a country that is not a less developed country and such income comprises over 20 percent of its entire gross income for such period.

In Commissioner v. Moline Properties, Inc., 319 U.S. 436 (1943), Ct. D. 1584, 1943 C.B. 1011, the Supreme Court, of the United States established legal principles by which a judgement could be made to determine whether a corporation was to be considered a separate taxable entity. The Court stated: "The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the State of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity."

In the instant case, both X and Y are completely separate taxable entities under United States concepts. X undertook hedging operations under its own name and Y operated copper mines under its own name. Although X hedged on the same commodity as produced by its subsidiary Y and the hedging transactions were conducted simultaneously with Y's shipments of copper, that in itself does not negate the separate entity principles established in Moline Properties, Inc.

Accordingly, gain from hedging operations in the instant case is income received directly by X from hedging transactions on the London Metal Exchange and X does not qualify as a less developed country corporation for the accounting period within the meaning of section 4916(c)(1)(C) of the Code since such income is sourced within a country that is not a less developed country and such income comprises over 20 percent of X's entire gross income for such period.